Do you really know how much you can afford to lose in the market?

Rob Isbitts is the founder of
Sungarden Investment Research,
an investment management and equity research firm. Over the past three decades, Rob has managed daily liquid
portfolios through diverse market conditions. He created several investment
strategies, including the
Sungarden Hedged Dividend portfolio, an alternative approach to the pursuit
of income, preservation and long-term growth. Rob has managed mutual funds and
authored two books. He can be
followed on Twitter @robisbitts.

Generally, when investors are asked if they know what their bottom-line, all-pain, this-is-how-much-I can-lose-no-question amount is, they have an answer. Here's a quick way to find out if you’re right.

Regardless of whether you are a short-term trader, long-term investor or somewhere in between, investing is "portfolio management" — choosing assets to invest in, allocating among them, making ongoing decisions about those assets individually, all with constant awareness of how those micro-decisions impact the portfolio as a whole. That portfolio-management process starts with you setting an acceptable range of outcomes, be it in percentage or dollar terms. But how do you set boundaries to do this, so that you get to where you want to be?

A breaking point: everyone has one

Thirty years into my investment-management career, there are a few things I am convinced are universal truths. One of them is that every investor has a break point. That is the amount of wealth at which their investment decision making (and maybe their sleeping pattern) is overcome by their concerns about the potential lifestyle impact of their investments.

Even though they realize that investment returns are cyclical, volatility comes with the territory, a mental switch flips for everyone at some point. And the closer we get to retirement, the faster that switch flips, and typically at a lower level of loss than when we were younger. This is natural, and no investor should be distressed by it.

What's your ‘number?’

However, I also believe most investors do not truly know what their stress point of loss is. I have used several "risk tolerance" surveys and tools, and I have concluded that the most direct way to figure out your true tolerance for loss is ... ask yourself. This sounds simple, but there is a catch.

You see, this is a tradeoff. You can't talk about how much you are willing to see your portfolio drop without also understanding what that means about how you limit your upside by doing so. But how do you figure that out? It would be nice if you could simply say "sign me up for 40% upside and 5% downside," but that is not realistic.

Real-life experience

The table below summarizes the historical six-month return ranges of some popular asset investment indexes going back to 2008. You may be asking why a six-month time frame is used, when I usually make such a big deal about judging investment results over a longer time period. The reason is that we are talking about the outer limits of what an investor can stomach over a shorter amount of time. If they can't take more than say a 5% return over any half a year, that excludes many potential approaches that require three years' worth of patience.

These are not the absolute best- and worst-case scenarios that have occurred. Instead, I used a "standard deviation" approach by having my research analyst, Mark Jakupcik, calculate the ranges within which each investment's returns fell 68% of the time and, separately, 95% of the time. (Jargon alert: The statistics students among us will recall that these are often used to express the possibility of something within one and two standard deviations of the mean, respectively. The key for you is that viewing it in this way, instead of expecting worst- and best-case scenarios to repeat themselves exactly, will help you to better understand what is possible and what is reasonable.)

Some observations

The ranges are a lot larger than many investors are comfortable with.

This is why I often write that comparing your portfolio to the S&P 500 is not a good idea for many investors. It sounds brazen, bold and heroic to say that you will be cool and calm when the "dips" occur, but take a gander at those numbers on the right and ask yourself if you are really up for that ride.

Many investors can benefit from an approach that is geared to play defense, not only offense. Bonds may look like they do that, but in reality, the figures on the last line of the chart reflect a bond market that has worked its way toward near-zero interest rates. I believe that in general, bonds offer scant upside, but catastrophic downside potential from this point forward.

All of this is in the context of what your unique objectives are. But without a serious discussion with the person in the mirror about what you can truly afford to lose without emotions overwhelming your strategy, the coming months and years could be challenging.

What's your risk number? My firm has made available to Marketwatch.com readers the Riskalyze risk-tolerance quiz. It takes about two minutes to complete, and by doing so, you can estimate your "investment comfort zone" for short-term market volatility. You will also be added to Sungarden's research distribution (email) list. You can go here to take the quiz.

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